How to invest in funds, investment trusts and ETFs - and save money as a DIY investor

Investing for the long-term: Funds, investment trusts and ETFs are the ideal vehicle for those looking to spread risk and save over a long period.

Investing in funds and investment trusts is the route often recommended to small investors by the experts.

Picking individual shares means you need to do plenty of research and spread your risk carefully, whereas buying a fund allows investors to pool their money with others to access a range of investments and avoid putting all their eggs in one basket.

There are a variety of ways to do
this, from the most popular 'fund' options, to investment trusts and
exchange traded funds.

Some tap into professional's expertise while
others simply track a certain index, some follow popular markets while
others allow access to obscure and adventurous corners of the world.

We explain what funds are, how to
invest, and how to save money by using a DIY investing platform.

What are funds?

When investors talk about funds they are typically referring to either unit trusts, or open-ended investment companies, Oeics.

This jargon may make them sound complicated but they are essentially just funds where investors' money is pooled to invest in shares, bonds or other funds.

The idea is that as the fund invests in lots of different companies' shares or bonds, the risk of you losing all your money is less than it would be if you were in a single company's shares.

Similarly, most funds will have a fund manager. This will be someone, typically with substantial investing expertise and experience, who will aim to beat the market and provide the best return for investors (although, often they do not manage to do so.)

When times are good a fund manager aims to do make higher gains than their peers, when times are bad a good manager will come into their own by continuing to make money, or just not losing as much as their peers.

WHY INVEST THROUGH AN ISA

Investing with an Isa is one of the few opportunities we have for making money with very little tax but it doesn't offer complete tax-free status.

Every year the Government gives us a tax-free Isa allowance. This has now been boosted to £15,000 under the new Super Isa regime.

Any gains within an Isa are free from capital gains tax. Everyone has a CGT allowance of £10,900 per year and many may feel they are unlikely to ever make more than this in profit each year from selling their assets.

However, those who invest consistently over time may one day be surprised at how much those investments are worth and holding them in a tax-free wrapper makes sense.

Income from investments is also treated in a more tax-friendly way in an Isa. Corporate bonds and gilts income is tax-free.

Dividends and shares income are still taxed at 10% before they are received, so basic rate taxpayers will not gain any extra benefit, but higher rate taxpayers do not have to pay any extra tax that would normally be incurred.

if you are a basic rate taxpayer you may hope to be a higher rate taxpayer one day, so putting your investments in a tax-free wrapper is a sound tactic. Investing through an Isa also removes the headache of filling in a tax return for both income and capital gains.

Investors have to make a minimum
investment, usually £500 to £1,000 to access a fund, and their
investment will either go up or down in value depending on how the assets it has bought have performed.

Funds typically have two versions: and accumulation class (acc) which rolls all dividend income back into the fund to boost growth, or an income class (inc) which pays out dividends to those who wish to have them as income.

Investment funds, the typical term for Oeics and unit trusts, carry two sets of charges
- an initial charge, which can take a chunk of your money when you put
it in, and annual management charges, which go towards the cost of
paying the fund manager and running the fund.

Initial charges can be up to 5 per cent but are easily avoidable through a good broker or platform.You do not want to be paying these.

Annual management charges vary, but were traditionally about 1.5 per cent with half of that going to financial advisers and platforms that sold the fund.

Financial regulations stopped these payments for new investments and new clean funds have been brought in, which typically charge 0.75 per cent to 1 per cent and pay no commission back to advisers or platforms

The arrival of clean funds has delivered a somewhat baffling array of types of the same funds. Each tends to have a letter than follows and there is little consistency as to what they mean. If you are looking for the new clean fund then you want what is called the unbundled version, the higher annual management fee types are called inclusive.

Annual management charges are taken from your investment every year and act as a drag on its performance.

Investment trusts, explained in more detail below, have typically had lower charges and did not pay any commission to advisers or platforms.

The annual management charge is not the true cost of investing, however, a closer estimate is the total expense ratio or its replacement measure ongoing charges.

The best way to invest is through an Isa wrapperwhich shields your investments and their growth from the taxman.

Globe trotting: Funds allow investors access to markets all round the world

What about investment trusts?

Investment trusts are less common and have not tended to be recommended as often by advisers as they do not pay them commission.

The crucial difference between them and funds is that investment trusts
are listed companies with shares that trade on the stock market.

They invest in the shares of
other companies and are known as closed end, meaning the number of
shares or units the trust's portfolio is divided into is limited.
Investors can buy or sell these units to join or leave the fund, but new
money outside this pool cannot be raised without formally issuing new
shares.

Investment trusts can be
considered riskier than unit trusts because their shares can trade at a premium or
discount to the value of the assets they hold, known as the net asset
value.

For example, a
trust's price can fall below the total value of its holdings, if it is
unpopular and people do not want to invest but do want to sell, thus
pushing down demand and driving up the supply of its units for sale.
This gives new investors the opportunity to buy in at a discount, but
means existing investors holdings are worth less than they should be.

One other useful aspects of income
investment trusts is that they can hold aside some money in the good
times to help pay dividends when things are tougher, in a process known
as smoothing. Some investment trusts, known as dividend heroes, can
boast very long unbroken runs of increasing their dividends City of
London has increased its dividend for 47 years in a row.

Investment trusts tend to be a
lower cost option than funds, with no initial charge and lower annual
fees, however, buying incurs share-dealing charges, again a good DIY
investment platform will cut these.

Research
has show that investment trusts have in many cases delivered better
performance than funds over time. Investors should be aware, however,
that buying investment trusts can carry more risk.

Firstly,
the share price at which you can sell out could fall to a level below
the value of what the trust holds, whereas an open-ended fund's price
always reflects that underlying value. Secondly, investment trusts can
borrow to boost returns, under a process known as gearing,
when times are good this can deliver market beating returns but when
share prices fall it can spell a bigger dip in an investment trust's
value.

There is an added advantage to investment trusts,
however, in that if markets fall and investors rush for the exit they
are not forced to sell assets at unattractive prices to let them redeem
their investment, as an open-ended fund would need to.

Instead,
an investment trust can opt to sit tight and ride out the storm and
those who want to sell out will simply find the market between buyers
and sellers sets the price of their shares in the trust.

A good place to find out more about investment trusts is the Association of Investment Companies - www.aic.co.uk

The tortoise and the hare: Passive investors believe that slow and steady wins the race, while active investors chase market-beating returns.

Passive or active funds

To complicate matters funds are typically divided into two categories active and passive.

Around one in four funds is passive, there is no stock picking involved, it simply buys the shares or market represented and therefore tracks it, ie a fund that mirrors the FTSE 100 and will deliver the same returns as that market.

An active fund on the other hand has a manager buying and selling assets, attempting to beat the market.

Some tracker funds are far more sophisticated than others. For example, Vanguard's LifeStrategy range and rivals allow investors to choose their risk levels and then buys a basket of assets that suits them, across shares and bonds around the world.

The advantage of a passive fund is that it is cheaper. These generally take two forms, either a tracker fund bought and sold in the same way managed funds are, or an Exchange Traded Fund, bought and sold in the same way shares are.

This low cost investing has become increasingly popular in recent years, especially ETFs which offer the chance to trade anything from the FTSE 100 and gold, to coffee beans and cotton.The more exotic the ETF the higher charges are likely to be.

Fund managers will tell you that the advantage of an active fund is their expertise, however, you actually have to choose the right manager to benefit from this, many consistently fail to beat their benchmark and still levy their fees - a handful do actually outperform year after year.

There is plenty of debate as to which side of the active vs passive argument is right.

Choosing a fund

There are thousands of funds to choose from and they are divided into different types or sectors. You can buy funds that invest in shares, corporate bonds, gilts, commodities and property, among other things, they will also typically have some form of geographical focus.

The wealth of choice means investors can target any theme they choose but can also make picking one baffling.

Most DIY investing platforms now offer some form of best buy or selected list of funds, which they consider to be those that will give you the best chance of success. All have different criteria for picking funds. Some platforms carry tools that help you choose funds and decide on how much risk you are happy taking.

If you are comfortable going it alone, our expert fund tips provide some pointers.

If you are unsure of how to invest speak to an independent financial adviser.

Buying funds and investment trusts

If you go direct to the fund company, you'll lose up to 5% of your investment as an initial charge, that makes this one of the areas of a life where a middleman pays off.

A financial adviser can help - but you must now pay them for their time either through an upfront fee, hourly rate or percentage of your investments, which for many small investors may prove overly expensive.

If you don't want help from a financial adviser, it is cheaper and easier to go through a DIY investing platform or an 'execution-only' broker, who does not give advice. They can provide access to funds, investment trusts and ETFs.

The best way to invest is through an Isa wrapper which shields your investments and their growth from the taxman

This may sound complicated but is actually simple. Once you identify your chosen platform, you can go open an account with them, pick your investments and choose to fund them with a lump sum, regular investments or both.

Platforms are easy to use, the best have helpful customer service on the end of the phone and you can manage your investments online. You can see all your investments in one place and often mix and match funds, shares, ETFs, investment trusts and more

FUND JARGON BUSTER

The investment industry's world of abbreviations...Acc: Accumulation - any income generated by the fund like dividends or interest is automatically reinvested.Inc: Income - any income generated is distributed by the fund instead of being reinvested. Dis: Distribution - any income generated is distributed by the fund instead of being reinvested. R: Retail - the fund is aimed at ordinary investors. I/Inst: Institutional - the fund is aimed at corporate investors like pension funds. A, B, M, X etc: Different fund houses use letters for different things. Check with them what they stand for. NT/No trail: Some fund houses use this name on clean funds which carry no commissions for financial advisers, supermarkets or brokers, just the fee levied by the fund manager. But other fund houses use different letters - I, D or Y, for example - so you need to find out for yourself which are clean funds. Gr: Stands for gross. GBP/£: Fund denominated in pounds. EUR: Fund denominated in euros. USD/$: Fund denominated in US dollars. Compiled with online stockbroker The Share Centre